Prudential Liquidity Management: What is this all about?
Buried in Annex 2 of Budget 2011, the Government announced changes to its debt management strategy. It proposes to increase its holdings of “liquid financial assets” by $35 billion in the form of domestic cash deposits and foreign exchange reserves. What does this mean and why is it doing this now.
The Government argues that cash reserves need to be increased in the event that normal access to financial markets is disrupted or delayed. With this increase in cash reserves, the Government would have sufficient cash on hand to cover at least one month of net cash requirements. It proposes to increase its holding of cash in financial institutions and with the Bank of Canada by about $25 billion (for first ten months of 2010-11, cash balances averaged about $12 billion), with the remainder held in US$ in the Foreign Exchange Fund Account. Reserves in this Account would continue to rise in order to maintain a level at or above 3 per cent of nominal GDP.
It is curious as to why the Government is doing this. In the mid-1990s, this was not the case. Canada, with second highest debt-to-GDP ratio among the G-7 and facing a potential separation, was close to hitting the debt wall. Fears were expressed that it would not be able to secure adequate financing to meet its day-to-day obligations. Today, that is not the case. Its fiscal situation is the best among the G-7 countries. With the ending of the stimulus funding and the repayment of the principal on assets maturing under the Insured Mortgage Purchase Program, the federal government’s new borrowing requirements are falling dramatically. By 2014-15, a net source (repayment of debt) of $35 billion is anticipated.
So why now? The Government could be concerned about sovereign debt crises in Europe and the ability of these to be resolved in an orderly fashion. It could be concerned about terrorism attacks on major financial centers. Or it could be that with an improving fiscal situation, the need to tap financial markets is less. In 2008-09, the Government consolidated the borrowing needs of three financial Crown corporations: Business Development Bank of Canada, Farm Credit Canada and Canada Mortgage and Housing Corporation, primarily to enhance the liquidity of the Government’s debt program. It appears that the Government feels it needs another vehicle to increase liquidity. The timing of this initiative coincides with the declining borrowing needs.
One thing that is of concern is that the Government does not need Parliamentary approval to increase its holding of debt. Changes to the Financial Administration Act in 2007 removed the statutory limit on borrowing. Previously, the Government only had standing authority to refinance its market debt but needed Parliamentary approval to undertake additional borrowing beyond an existing $4 billion of non-lapsing borrowing authority. At the time, the proposed change received virtually Parliamentary scrutiny. However, after the fact, Parliament felt that it had lost an important element of control and oversight over Government finances.
The Government states that the increased liquidity will have no material impact on the budgetary balance as the increase in borrowing costs will be offset by increase in returns on interest-bearing assets. Since when has the rate of return on cash balances equaled interest charged on loans.
If this measure is re-introduced, Parliament should actively debate and question the rational for the increased liquidity. Parliament dropped the ball in 2007. It should ensure it does not do it again. In our view, there needs to be more Parliamentary control, not less, over the amounts of funds the Government can borrow and for what purposes. Hopefully, at some point in time, there will again be a statutory limit on borrowings, one that can only be changed with Parliamentary approval.